23 May 1990 Ministerial Letter 900298 F - Corporate Reorganizations Course Material

Please note that the following document, although believed to be correct at the time of issue, may not represent the current position of the CRA.
Prenez note que ce document, bien qu'exact au moment émis, peut ne pas représenter la position actuelle de l'ARC.

SUBJECT: Review of Corporate Reorganizations Course Material  Lesson 6 Capital Gains Strips - Section 55

This memorandum is in response to yours of April 3, 1990 wherein you requested our technical review of the Corporate Reorganizations Course Material comprising the Instructors Lesson Plan and the Participants Package.  This memorandum contains our comments on Lesson 6 Capital Gains Strips - Section 55.

Our comments are as follows:

1.     On page HO/2, paragraph 5 we would suggest that you include a reference to "Questions Concerning the Butterfly Reorganization" which represents Revenue Canada's contribution to a joint paper titled "Revenue Canada's Administrative Practices and Other Issues Relating to Butterfly Reorganizations" which was presented by R.J. Dart, H.J. Kellough and Michael Hiltz at the 1989 Conference of the Canadian Tax Foundation. You may also wish to include this article in your reading list as it will be included in the 1989 Conference Report when it is published.

2.     Page HO/8.2 discusses the term "series of transactions or events".  On page 7:6 of an article titled "Section 245 of the Income Tax Act" which is found in the 1988 Conference Report, Michael Hiltz made the following comments concerning the Department's interpretation of this term:

     "In the view of Revenue Canada, a preliminary transaction will form part of a series determined with reference to subsection 248(10) if, at the time the preliminary transaction is carried out, the taxpayer intends to implement the subsequent transactions constituting the series, and the subsequent transactions will be part of a series even though at the time of the completion of the preliminary transaction the taxpayer either had not determined all the important elements of the subsequent transactions - including, possibly, the identity of other taxpayers involved - or had lacked the ability to implement the  subsequent transactions.  A simple example will illustrate this interpretation.  Assume that a taxpayer owns an inventory that he wants to sell.  If he sells the property directly, the proceeds of disposition will be included in computing his income. Before the taxpayer finds a purchaser for the property, he transfers the property to a newly incorporated company (Newco) in exchange for shares, and elects under subsection 85(1) at the cost amount of the inventory.  Eventually, the taxpayer locates a purchaser and sells all the shares of Newco, reporting the proceeds as a capital gain.

     The transfer of the property to Newco would be included, by virtue of subsection 248(10), as part of a series of transactions that included the sale of the shares of Newco to the purchaser, even though the taxpayer did not know the identity of the purchaser at the time he transferred the property to Newco.  All  that is necessary for the transfer of the property to Newco and the sale of the shares of Newco to be part of a series is that the taxpayer intends that the property be disposed of by selling shares and that he carries out that intention."

     Although this article relates to GAAR, it is our view that  these comments are equally relevant for purposes of subsection 55(2) of the Act and should be included in the Participants Package.

3.     With respect to the first sentence of the first paragraph on page HO/8.4, it is our opinion that the Act does provide definitions of "income earned or realized by a corporation" (commonly known as "safe income") in paragraphs 55(5)(b), (c) and (d) for various types of corporations.  On page 18:3 of Robert Read's paper found in the 1988 Conference Report of the Canadian Tax Foundation it is stated under the heading "Safe Income The Definition and Time of the Calculation":

     "Paragraphs 55(5)(b), (c) and (d) define income earned or realized by a corporation" for purposes of subsection 55(2).  "Income earned or realized" or "safe income" with respect to a share of a corporation refers to ...."

4.     The example in the third paragraph of section 4.2 on page 9.1 of the Participants Package and page 22 of the Lesson Plan is, in our view, somewhat misleading since it suggests that a taxpayer can indiscriminately make as many designations under paragraph 55(5)(f) as it wishes.  On page 18:10 of his article "Section 55:  A Review of Current Issues" which is published in the 1988 Conference Report, Robert Read indicates that a taxpayer should explain the specific uncertain elements in the calculation of safe income which resulted in the need for more than one designation.

5.     It is our opinion that the statement contained in the third paragraph on page HO/9.2 is incorrect.  Safe income is allocable to each share held in the holding period.  When a share is redeemed, subsection 55(2) will apply if it can be shown that all or a portion of the inherent capital gain is attributable to something other than safe income. Therefore, a redemption of shares in several stages would not stop the application of subsection 55(2) because not all of the safe income would be allocated to those shares which are redeemed first.  Refer to  page 86 of J.R. Robertson's paper in the 1981 Conference Report and Question 5 on page 18:26 of Robert Read's paper in the 1988 Conference Report.

6.     With respect to the third paragraph under the heading "Miscellaneous Adjustments" on page HO/1O.3 of the Participants Package and the second point under the heading "Miscellaneous Deductions" on page 26 of the Lesson Plan, the portion of the capital loss that would be ignored in calculating safe income is not necessarily one half; i.e. it is one-third for capital losses realized in 1988 and 1989 and one-quarter for those realized in 1990 and subsequent years.

7.     The comments under the heading "Rollovers" on page HO/13.2 of the Participants Package and page 33 of the Lesson Plan are somewhat misleading since they suggest that safe income follows a share whenever a rollover provision is used.  This is only true where the adjusted cost base of the share to the transferee is the same as that of the transferor.  Where, for example, a subsection 85(1) rollover is made at an agreed amount which exceeds the transferor's a.c.b. of the shares, it is our view that not all of the transferor's safe income in respect of the share will flow to the transferee.  A portion of this safe income will now be reflected in the transferee's a.c.b.  For more details we refer you to an article titled "Is Safe Income a misnomer?" in the August 1989 issue of CA Magazine which you may wish to include on your reading list.

8.     With respect to the first sentence of the second paragraph on page HO/13.3 under the heading "Stock options", we suggest that, to add clarity to the subject matter, the following words be added immediately after the expression "fair market value of the shares":

     "at the time the option was issued"

9.     With respect to the first sentence of the first paragraph under the heading "Stock dividends" on page HO/13.4, we suggest that the opening words be changed as follows:

     "Depending on the relative amounts of the gains inherent in the shares received as stock dividends and in the shares ...."

10.     On page 13.4, we question the relevance of the second paragraph under the heading "Earnout clauses".  In this paragraph the author is discussing the times earning method of valuing a business, which, in our view, is unrelated to the issue of earnout clauses.  Earnout clauses are discussed in IT-426 and their implications for purposes of calculating safe income are described on pages 94 - 95 of John Robertson's article in the 1981 Conference Report.

11.     In our opinion the first paragraph on page HO/14 of 3 is incorrect in that subsection 55(3) provides only two exceptions. Paragraph 55(3)(a) represents one exception which will not be available if either of the results described in subparagraphs (i) or (ii) thereof exists.  See also page 38, paragraph 3, of the Lesson Plan.  Similarly, the first paragraph of section 6.2 on that page is incorrect.  Subsection 55(2) could also apply where there is a significant increase in the interest in any corporation by an arm's length person.

12.     The comments in the first paragraph of section 6.4 on page HO/14.2 are also incorrect.  If the purpose or result tests enunciated in subsection 55(2) are met, subsection 55(2) will apply where the dividend was received as part of a transaction or event or a series of transactions or events that resulted in a significant increase in the interest in any corporation of any person with whom the corporation that received the dividend was dealing at arm's length.  Therefore, in the third paragraph on page HO/14.3 and the second expected response on page 37 of the Lesson Plan it should be made clear that the exception in paragraph 55(3)(a) will not be available in the example described by virtue of subparagraph (ii) thereof.

13.     Under section 7.2 on page HO/15.2 of the Participants Package and page 38 of the Lesson Plan it mentions that butterflies may be undertaken to purify a small business corporation.  In view of the exception found in paragraph 110.6(7)(a) of the Act and the Department's interpretation of the term "series of transactions or events" as discussed in comment 2 above, it is our view that a butterfly reorganization would not be an effective method for purifying a small business corporation.  We, therefore, recommend that this comment be deleted from the course material.

14.     On page HO/17 you may want to mention that after Opco repurchases its common shares held by B Ltd., A Ltd. will have acquired control of Opco and that the provisions of subparagraph 256(7)(a)(i) will not apply even if A Ltd. and B Ltd. are related since A Ltd. has not acquired any shares of Opco.  Therefore, all of the consequences resulting from an acquisition of control will be realized.

15.     With respect to the first point under "Step 2" on page HO/18, we suggest the sentence be amended as follows:

     "Each of A Ltd. and B Ltd. redeems its preferred shares in exchange for promissory notes in the amount of $200,000.

16.     With respect to the first point under "Step 3" on page HO/18, the assumption that the aggregate fair market value of all of the common shares of Opco is $1,000,000 has not been stated in the preamble of the example. Also, this step should make it clear that the common shares are  purchased from each of A Ltd. and B Ltd. on a proportionate basis.

17.     In section 7.6 it should also be mentioned that problems can arise where property of the particular corporation is transferred to a shareholder transferee in the proportion required by paragraph 55(3)(b) but the series of transactions does not end with this transfer.  If the "reorganization" includes a subsequent transfer of property by the transferee corporation to a subsequent transferee or by the particular corporation to the transferee corporation the requirements of paragraph 55(3)(b) would not be met on the basis that the subsequent transferee or the transferee received a share of property of the particular corporation that was not commensurate with the value of its shareholdings, if any, in the particular corporation immediately before the original transfer.  Although we do not have any clear guidelines as to when a subsequent transfer will be "in the course of a reorganization", it is our general view that a subsequent transfer of property, whether on a taxable or tax-deferred basis, to a shareholder of the particular corporation or to a person which does not deal at arm's length to a shareholder will normally be considered to be "in the course of the reorganization".  It is, however, our practice that taxable sales of butterflied property by a transferee to an arm's length party will not ordinarily cause the paragraph 55(3)(b) exemption not to apply.  Similarly, a taxable sale of butterflied property between transferees or from a transferer back to the particular corporation simply for balancing purposes where the property sold is used in the same business as other assets acquired by the transferee or remaining with the particular corporation on the butterfly will not ordinarily cause the butterfly to be offside.

18.     On page HO/20.2 of the Participants Package and page 63 of the Lesson Plan there is a discussion concerning the use of a subsidiary as a conduit.  Where the butterfly is accomplished by transferring property of the particular corporation to a wholly-owned subsidiary of its corporate shareholders we agree that the subsidiary must be wound up to satisfy the direct or indirect transfer requirement.  Where, however, the particular corporation, relying on subparagraph 55(3)(b)(vi), transfers property to one of, its subsidiaries and the shares of this subsidiary are then transferred to a shareholder of the particular corporation as part of the butterfly it is no longer our view that the subsidiary corporation will have to be wound up.  In our view the property of the particular corporation, which is transferred directly to the shareholder transferee will in this case be the shares of the subsidiary. Although this position is different from that set out at page 18:22 of Robert Read's 1988 paper, it represents our current views and will be updated when the paper referred to in comment 1 above is published.

19.     It should be noted that the exception described in section 7.8.2 on page HO/20.4 of the Participants Package and page 65 of the Lesson Plan applies only to situations where the shareholder owns only qualifying preferred shares.  If the shareholder owns any common shares or high/low preferred shares of the particular corporation this administrative position does not apply.  See the first paragraph on page 44 of the 1984 Corporate Management Tax Conference  Report.

20.     With respect to section 7.8.3 on page HO/20.4 of the Participants Package and page 65 of the Lesson Plan it is our view that where land held as inventory is transferred into a partnership in contemplation of a butterfly reorganization and it is not intended to dissolve the partnership within a short period of time that the acquisition of the partnership interest by the particular corporation will be an acquisition of property in contemplation of the butterfly.  Since such acquisition does not fall within one of the exceptions described in subparagraphs 55(3)(b)(iii) to (viii), dividends received on the subsequent butterfly reorganization would not be eligible for the 55(3)(b) exemption.

21.     We suggest that the comments under section 7.9.2 "Fair Market Value of Property Received" on page HO/20.6 be deleted and replaced with:

     "The term 'property' does not encompass liabilities and, therefore, the pro rata test found in paragraph 55(3)(b) contemplates a transfer of property at its fair market value (i.e. gross value without taking into account the liabilities attached thereto).  However, it is our administrative practice that in determining the fair market value of property for the purposes of paragraph 55(3)(b), it is acceptable to deduct liabilities from the gross value of assets if our administrative guidelines regarding the allocation of liabilities, as described below, are  followed (the net equity method).

     In determining the fair market value of each type of property using the net equity method, liabilities (determined on a consolidated basis, where appropriate) are allocated to, and deducted in the calculation of, the net fair market value of each type of property (determined on a consolidated basis, where appropriate) generally as follows:

     (i)   current liabilities are allocated to cash or near cash property, including accounts receivable, inventory and prepaid expenses, in proportion to and to the extent of, the fair market value of all property of that type;

     (ii)   liabilities, other than current liabilities, that relate to a particular asset are allocated to the particular asset and to the type of property of the particular asset to the extent of the fair market value of the particular asset and any such liabilities not so allocated are considered to relate to the type of property of the particular asset but not to the particular asset for the purposes of the allocation described in subparagraph (iii) below;

     (iii)   liabilities, other than current liabilities, that  relate to a type of property but not to a particular asset are allocated to that type of property to the extent of the net fair market value, determined after the allocation described in subparagraph (ii) above, of that type of property; and

     (iv)   any liabilities not otherwise allocated in accordance with subparagraphs (i), (ii) and (iii) above will be allocated to all types of property in proportion to, and to the extent of, the net fair market value, determined after the allocations described in subparagraphs (i), (ii) and (iii) above, of each type of property.

     Where the person who will own the accounts receivable, inventory or prepaid expenses after the butterfly will carry on the business to which those properties relate, the net value of those properties as determined after, the allocation of current liabilities described in (i) above, may, if the taxpayer so chooses, be included in net business property before making the allocations described in (ii), (iii) and (iv) above."

     Similar amendments may also be needed to the points mentioned under the heading "Treatment of Liabilities" on page 67 of the Lesson Plan.

22.     We have some difficulty with the comments contained in the second paragraph of the response to part (d) on page AN/22.2. In our view the consequences of subsection 55(2) should be the same regardless of whether the dividend paid is a stock dividend or a cash dividend. Although the stock dividend may increase the adjusted cost base of the shares the fact that no cash, has been paid out by the company should mean that the purchaser will pay $500,000 more to acquire the shares. Where subsection 55(2) applies the net effect in either case should be that the amount of capital gain reported will be increased by the amount of the dividend by virtue of paragraph 55(3)(b).

23.     We suggest that the reference to Question 61 of the 1987 Revenue Canada Round Table under the heading "Revenue Canada, Taxation" on page HO/23.l of 4 be deleted because subsection 112(8) of the Act was never enacted.

We have not been provided with copies of the overheads and other teaching aids mentioned in the Lesson Plan and, therefore, offer no comments on these items.

for DirectorReorganizations and Non-Resident DivisionSpecialty Rulings DirectorateLegislative and Intergovernmental Affairs Branch